Markets and macro under stress

  • Business
  • Saturday, 27 Feb 2016

THE news flow on macro data and financial markets since the beginning of the year is not for the faint-hearted.

The Shanghai composite index shed 7 on the first day of trading in 2016 while the Dow Jones Industrial Average has lost around 7% year-to-date until mid-February.

Meanwhile, in China, its gross domestic product (GDP) eased to 6.9% growth in 2015, the slowest rate recorded since 1990.

Brent crude oil price remains depressingly low, averaging US$32 per barrel in January as gold price shot up over 15% in the last two months since mid-December 2015.

Amid tumbling crude oil prices and global market jitters, Malaysia markets and macro were not spared.

The Finance Ministry had to revise Budget 2016 and it sees limited upside to GDP growth this year, cutting the official projection range from 4%-5% to 4%-4.5%.

What is causing the downward trend and is there a bottom to it? These are burning questions confounding investors and policy makers.

> Understand context to figure out what is going on

In the financial markets, investors appear to be digesting the implications of widening divergence in global monetary policy.

The European Central Bank (ECB) and the Bank of Japan (BoJ) are currently pursuing monetary easing through quantitative easing (QE) worth 60 billion euros and 6.7 trillion yen per month respectively.

On the other hand, following its interest rate lift-off last December, it remains to be seen if the United States Federal Reserve will proceed with the subsequent rate hikes that it has previously forecast.

Furthermore, the ECB and BoJ have undertaken unconventional routes by experimenting with negative policy rate (ECB -0.3% since December 2015 and BoJ -0.1% since February this year) on its deposit rate and interests on excess reserves respectively in addition to their QEs.

What was once thought as practically impossible and almost never mentioned in business and economic lectures was for a central bank to set its benchmark interest rate lower than 0%, effectively making the banks to pay the central bank to deposit money with it.

From a macro perspective, the traditional monetary policy tools appear ineffective to fend off prolonged sluggish domestic growth and the growing threat of deflation in the euro zone and Japan respectively.

For instance, in Japan, fourth quarter GDP growth contracted 0.4% in annualised terms, down from a tepid 0.3% expansion in the third quarter. With inflation growing at a disappointing rate of 0.2% last December from a year ago, down from 0.3% recorded in November, it is not surprising that the BoJ is eager to go all out with its monetary expansion.

Hence, the bold step to introduce negative interest rate is to encourage more money flow in the banking system for consumption loans, capital expenditure and activities that spur economic growth.

> What are the consequences?

Unfortunately, nothing in economics and financial markets is ever unilateral.

Not only does monetary policy affect exchange rate movements, the market anticipation of future monetary policy itself will immediately feed back into financial markets.

In early February, Bloomberg reported that up to US$7 trillion worth of sovereign bonds globally are priced with yields that are sub-zero, meaning that investors who hold on those debt until maturity will incur a loss.

In an ideal economic and financial market model, negative bond yields do not exist. But we are not in an ideal macro environment that generates growth and good returns now.

The key drivers of economic growth and sustainable financial market returns appear lacking at the moment.

In fact, at the beginning of the year, the International Monetary Fund (IMF) had cut its global growth projection for this year to 3.4%, from a projected 3.6% last October, on the back of expected further slowdown in the Latin American region and depressed commodity prices.

On the other hand, China’s slowdown has not turned around yet.

China’s exports continue to contract in January, declining further by 11.2% from a year ago after a drop of 1.4% last December.

This is not a positive development for the Asian economies, as the trade flows in the region are highly interlinked with the Chinese macro performance.

> Next trigger remains uncertain

Currently, there is no convincing and coherent consensus on the impending market and macro risks that could blow up in the near term.

Keep in mind that during the US financial crisis of 2007, default in subprime loans – one of the main triggers to the financial fallout – and the subsequent turmoil in the derivatives markets were not clearly identified by the markets and regulators until it was already too late.

Moreover, post-Global Financial Crisis, debt levels of sovereigns, corporates and households around the world have increased by up to US$57 trillion, according to a McKinsey report on debt and deleveraging in 2014. This is worrisome.

Higher leverage, if unsustainable, poses serious systemic risks to an economy as past financial crises have shown.

Therefore, the concerns arising from the financial market remains the grave mispricing of risks in dodgy assets or wrong assumptions of no correlations between asset classes that in actuality, moves together following a market trigger.

The next trigger to a financial meltdown could arise from any part of the world or even the least expected places. When interest rates do actually go negative, it would take an ignorant optimist to believe that even safe havens assets are guaranteed rock solid safe.

To remind ourselves how fragile the globalisation of financial markets could be, it might only take a few big desperate sellers and the absence of buyers to send financial markets spiralling downwards in a flash crash.

Malaysia’s real GDP growth of 5% recorded in 2015 was commendable given the challenging macro environment. Unfortunately, as a small open economy, Malaysia remains constrained by forces of external market and macro influences.

To a large extent, the ringgit continues to be swayed by international portfolio rebalancing on the back of uncertain global monetary policy directions and news flows on crude oil prices and production levels.

In turbulent times, solid macro fundamentals and confidence in the domestic economy are pillars of resilience to ride through the rough patches.

While an impending recession is not the base case assumption, it is important to pay a closer look at what the worst case scenario could be.

Hopefully, there are no major macro policy missteps that could aggravate the situation and may the governments be diligent in implementing structural changes to reform respective business environments, nurturing the much needed seeds for growth.

Manokaran Mottain is the chief economist at Alliance Bank Malaysia Bhd.

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